Greetings from the Aspen Institute Security Forum, the inaugural—and so far excellent—security and counter-terrorism conference at the Aspen Institute, directed by my friend and colleague Clark Ervin, the former Inspector General of DHS.

The conference is abuzz with the words of Admiral Michael Mullen, Chairman of the Joint Chiefs of Staff, who spoke yesterday and twice raised the topic of terrorist synergies: the joining of forces between previously unrelated and even mutually distrusting terrorist organizations. Having spent the week fighting the fire that was Gen McChrystal’s dismissal and just himself back from a trip to Afghanistan, Pakistan and Israel, it is clear that Adm. Mullen was a man on a mission to identify and address this new phenomenon of terrorist cooperation.

The term and concept are relatively new: there has previously been talk of criminal-terrorist synergies, but in general those reflected local alliances made, if not as a matter of expedience, certainly not with a view towards a global strategy. The trend has existed for a while: as the Hon. Fran Townsend (former Assistant to the President for Homeland Security and Counterterrorism) pointed out today, the trend began early in the Bush Administration: Indonesia’s Jamaat Islamia overtly supporting Al Quaeda; Sudan’s GSPC aligning similarly, etc. But US officials, at least, have taken some comfort in the rifts within Islam and the assumption that, for example, primarly Sunni organizations like Al Quaeda would not join forces with Shiite regimes such as Iran.

Take comfort no longer. There is a palpable sense among officials here that we are now fighting a globally decentralized, cooperating terrorist network which is willing to forego internal idealistic disagreements in favor of the ultimate goal: damaging the West and, specifically, the United States. We have graduated from a multitude of fights against separate entities to a unified fight against global terrorism.

18 months ago, the Treasury and the Fed embarked on unprecedented measures to save the US economy from collapse.  On Friday, Treasury reported that repayments of TARP exceeded loans for the first time. So I got to thinking:  did the much-vaunted monetary policy strategy have much to do with the stabilization?

First, a quick refresher from my “Monetary Policy is Working–A Little” post back in November 2008:

1. 1. The Fed did everything it could to fuel the money supply¹  in late 2008.  In 2 months, it increased the base money supply by 43%

      

   2. The Fed’s efforts dwarfed analogous (but much smaller) efforts after 9/11 to keep the economy from tanking:

      

   3. At the time, everyone understood that, while the Fed could increase the base money supply, it can only effect “narrow money,” and it would take a while for the broader money supply (including credit) to feel the impact.

So, what were the results. ::drum roll::

You will be forgiven for thinking that the results are a whole lot of nothing.  They basically are:  a completely unprecedented, roughly $1.5 trillion increase in the money supply, and zero noticeable impact?! What gives?  Our expectations.  ed note 7/5/2010:  stay tuned for a post explaining why the Fed’s printing money didn’t work.

I’ll close with one more interesting statistic:  thanks to the John Williams at Shadow Government Statistics, we can track an old friend.  For the past three months, M3, the broadest measure of the money supply, and a statistic no longer tracked by the Fed, has been growing increasingly slowly.  Just this month, it stopped growing altogether.   M3 contains all of the money supply measured by M2 but also includes all other CDs (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements.

What’s going on here?  Unfortunately, it is clear that the Fed’s monetary expansion simply didn’t result in a broader money supply increase. In fact, there was a contraction. One could argue that the money multiplier was therefore negative.

ed note 7/5/2010: stay tuned for a post about why monetary base expansion worked better in China than the US.

1. For an excellent explanation of all these money supply measures, see http://www.shadowstats.com/article/money-supply. [↩]

Sadly, today’s news that Karachi suffered a suicide bomb attack  only serves to add a new dimension to concerns I originally raised in a post earlier this year (which I wrote from my Karachi hotel room on the evening of President Obama’s inauguration but, for security reasons, was unable to post until I left Pakistan).  Now, in addition to the dynamic I posted about (a state driven to the brink of destabilization by an extremist minority), we must add the Law of Unintended Consequences:  the possible “collateral destabilization” resulting from increased US troop presence in Afghanistan.

Asif Hassan/Agence France-Presse – Getty Images

Insidious forces of extremism continue to erode core Pakistani political and governmental functions.  Indeed, this particular suicide attack focused on Karachi, which lies at the southwestern-most end of Pakistan and, along with the rest of Sindh Province, has enjoyed relative peace and tranquility since the high profile attacks against Western targets it saw in 2002.  These attacks thus portend a serious escalation of the destabilization–and all of this despite (or perhaps because of–keep reading!) a continued US commitment to the region in the form of a time-limited commitment to Afghanistan.  Indeed, today’s Associated Press notes the recent increase in Haqqani network attacks on Pakistani intelligence and security operatives in North Waziristan is further straining US-Pakistani relations.  (The Haqqani network is an Al-Quaeda linked Afghani Taliban faction operating on both sides of the Afghan/Pakistan border.  Its increased activity may or may not be a result of an increased US activity in Afghanistan, but its recent impact on Pakistani ISI is nonetheless serious and potentially the source of some Pakistani concern over US activity.)

As well-known Washington Post correspondent David Ignatius pointed during a fascinating session at the recent Leading Thinkers Washington Forum on US-Pakistan relations, Pakistan both welcomes increased US commitment to Afghan stability (and thus to avoiding Afghanistan’s return to the status of a failed state), but also has cause for concern because of the possibility that more US troop pressure in southeastern Afghanistan will result in more insurgent activity both in the Swat valley (to the northeast) and in Pakistan’s Waziri provinces (to the northwest)–via a kind of chaotic osmosis destined to bring only increased threats to Pakistani stability.

One way or another, the conclusion is clear and worrisome:  Pakistan is heating up, and the US’s “Afghan Surge” has not quelled the hostility or the unrest.  If anything, the unintended short-term consequence of the US efforts in Afghanistan may be increased internal tension and terrorist activity in Pakistan.  Let’s hope we can complete the task in Afghanistan sufficiently quickly to avoid permanent destabilization of its neighbor to the south.

[ed note: for security reasons, I was unable to post this until I returned from Pakistan. Yesterday’s kidnapping of an American UN Officialnear the same region I visited (the Sind province) provides a vivid explanation of why.]

There was something surreal about watching President Obama take the oath of office from a hotel room in Karachi, Pakistan. Several times, I wondered whether there were more suicide bomb barriers surrounding his dais or my hotel. Suicide bombers had nearly destroyed the hotel a year or two earlier, and the predictable reaction—to erect sufficient vehicle barriers to stop more than one simultaneous attack—had of course been implemented. And so I watched, from 13,000 miles away, as America took what I profoundly hope will be the first of many steps towards reestablishing its international reputation as a symbol of freedom, all the while knowing that I was under strict orders from our hosts not to leave the building.

All around me were little security instruction sheets, thoughtfully Xeroxed by the hotel staff and placed in every room. From the typical (“this water is unsafe for drinking; kindly enjoy the complimentary bottle of mineral water provided”) to the stern (“do not stand on balcony; snipers may be active”), the warnings combined to deliver the message that, thanks to the efforts of less than 1% of the population, Westerners are simply not welcome in Pakistan. 99% of Pakistanis we met were hopeful, interesting people, happy to talk to an American (and to ask us about our new president—more about that in a different post). But all I had to do was look out my hotel room window to realize that it is the 1% who rule the country.

View from my Karachi Hotelroom

As they so often do, this picture tells the story better than I can. The balcony is enclosed in a net, lest grenades be thrown up onto the landing. The wires above the pool are for god-knows-what security technique. (My guess: since they are either grounded or energized, probably an anti-eavesdropping measure which doubles as a mechanism for defeating radio frequency bomb triggers, although my mobile phone worked just fine underneath them, so perhaps not.) There were magnetometers, x-ray machines in the lobby, and nearly every entrance to every building was peopled by thoroughly un-reasuring armed guards. There were small trucks parked in the parking lots of both “Western” hotels, each filled with four chain-smoking Pakistani infantrymen, on top of which was mounted what looked like an M60 (.50 caliber machine gun). Two bomb-sniffing Labrador retrievers worked the parking lot. ID checks were performed endlessly.

I doubt that any experience since 9/11 has reminded me that this really is a war. Not a war which gives our government the right to abrogate our Constitution, but a war nonetheless. And until it ends, Americans traveling abroad had better remember that the actions of our own government (and in particular the recently-departed administration) catalyze reactions abroad which pose as grave a threat to our well-being as any other. (Until 2002, there had been no attacks against Western targets in Karachi. That all started after we reacted to 9/11.) In the end, no matter how hopeful I am that the inauguration of President Obama will set us off to righting our standing worldwide, we will remain “the enemy” for a long time to come.

I just spent an uncomfortable hour watching the CEOs of Ford, GM and Chrysler testify in front of the Senate Banking committee on C-SPAN.  (I’m not normally a C-SPAN viewer, but extraordinary times call for extraordinary viewing.)  As a CEO, I have spent my recent days in part engaged in battling the ramifications of the downturn.  So it’s hard to listen to these three guys, with whom I share a title—if not the unfathomably large businesses—and not feel for them.

source¹

To listen to Robert Nardelli (Chrysler, formerly CEO of Home Depot), his company has minutes remaining.  I’ve certainly expressed a sense of urgency before in my job when working to close a deal, but it’s impossible to listen to him and not sense something profound.  Three of our great industrial giants are willing to speak publicly about endgame.  Rick Wagoner (GM) seriously discussed a “pre-packed” Chapter 7 bankruptcy (surely a trial balloon alternative if ever I’ve heard one) by quoting marketing studies which show consumers are overwhelmingly unwilling to buy a car from a bankrupt company.  When was the last time you heard the CEO of a major non-financial company speaking about such potential downsides alongside his competitors? Extraordinary times indeed.

But not extraordinary enough.

Towards the tail end, Alan Mullaley (Ford, formerly Boeing) was asked whether his company would exceed the new CAFE fuel economy standards.  His response?  That Ford would barely be able to make them, and would not be able to exceed them.  The others agreed with him.  That one response convinced me that any bailout of US automobile manufacturers should 1) be totally focused on saving jobs (millions of them, potentially), and 2) must be so severely punitive of the companies themselves that they don’t get out of jail free.  These three companies have succeeded in lobbying their way out of innovation legislation (fuel economy, safety, public transport, etc.) for decades.  Consumers have responded by choosing foreign manufacturers preferentially (e.g. Toyota who pushed hybrid technology as a differentiator).  US manufacturers drop to the bottom of the list of consumer choices because of the manufacturers’ complacency, and then a contraction comes along and endangers the bottom of the barrel.  Surprise, GM, Ford, Chrysler, you now inhabit the bottom of the barrel precisely because of your complacency!

A little capitalist Darwinism is in order here.  If these guys had worked on fuel economy and alternative technologies 20 years ago, CAFE standards would be unnecessary now.  For want of those prior investments, it is not the Government’s job to subsidize their lack of business skills.  Do what we need to to save the jobs (lest we further endanger the economy), but otherwise I vote let these companies suffer the fate of others who stick their heads in the sand.

1. Businessweek online, “Auto Execs in the Hot Seat” http://www.businessweek.com/bwdaily/dnflash/content/nov2008/db20081118_113319.htm?chan=rss_topStories_ssi_5 [↩]

Earlier this week I posted some background material recalling how real interest rates were negative in the mid ’00s, thus inducing wild/out-of-control borrowing (all of which was looking for places to invest—think CDOs).  I was planning to use these data to back up my sense that the Fed’s recent rate cut was at best insufficient (I may still be right) and at worst dangerous (looks like I was wrong).  The latest data¹ (released on Friday, a few days after I posted) show that the Fed is pumping unfathomable amounts into the monetary base, and it’s just barely keeping monetary supply from falling off the table.

To get a sense for what the Fed has done recently, take a look at the utterly unprecedented jump in the adjusted monetary base²:

Your eyes are not deceiving you:  the Fed has pumped an unbelievable amount of money into the monetary base.  Classic monetary policy at work, right?  Well, it’s certainly an implement out of the classic monetary policy toolbox, but this is an unprecedented action:

Now the critical question:  is it working?  Well, a little.  In comparison to the monetary adjustments made after 9/11 to offset the economic shock, the current adjustments are three to four times bigger, but they’ve had a substantially smaller impact on the broader money supply³:

Compare the two red arrows in the second figure to the orange arrows in the figure immediately above.  The absolute adjustment to the monetary base (red arrows) in 2001 was somewhere between a quarter and a third as big as the utterly unprecedented influx the Fed just let loose, but the results (orange arrows) is barely noticeable.  What’s going on?  The simplest explanation I’ve heard comes from Bob Brinker, who explains that M2 has seen the impact of the past two months’ massive evaporation of wealth, while the absolute currency (monetary) base hasn’t.  To my eyes, we can therefore visualize the “spread” between BASE and M2 on the right-hand side above as that very evaporation itself

Speaking of spreads, it looks like there’s another indicator that the Fed’s policies are working a little.  The TED spread⁴ has improved dramatically:

Recent TED Spread history. ⁵

All of this points towards a similar conclusion to the one I hinted at in my post earlier this week:  monetary policy alone isn’t going to solve this problem.  A solution will require some time and some fiscal policy—both of which will have to wait for the end of the lame-duck period and thus for 2009.

1. the St. Louis Fed reports most of its major money supply “observations” every week, on Fridays [↩]
2. the Fed series is called “BASE” and you can find it, and the rest of the measures (“series”) I am referring to in this post on FRED at http://research.stlouisfed.org/.  The BASE data, for example, can be found at http://research.stlouisfed.org/fred2/series/BASE. [↩]
3. as measured by a different Fed series, called M2, which is physical currency (M0) plus demand deposits such as checking (M1) plus all manner of time deposits (savings, CDs, etc.).  For an explanation of the various money supply measures, see http://en.wikipedia.org/wiki/Money_supply. [↩]
4. difference between LIBOR and the 91-day Treasury Bill, roughly indicating the price of the credit supply [↩]
5. source: Bloomberg, http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP%3AIND [↩]

[editorial note:  Some of you saw this post earlier this week;  others were foiled by a strange Internet Explorer incompatibility induced by Microsoft Word.  Leave it to Microsoft to produce a word processor whose HTML output is incompatible with their own web browser.  All fixed now.]

Later this week, I’m going to argue that the Fed’s recent rate cut is at best an exercise in futility and at worst a mistake.  [another editorial note:  turns out I was wrong, at least on the second part.  exercise in futility perhaps, mistake, no.  see my next post.] First, it’s time to lay the groundwork:

The Creation of Free Debt¹

In the early days of the bail-out debate (way back in the first week of October), Robert Reich gave a talk at the Commonwealth Club in which he, rightly, laid part of the blame for the origins of the current economic crisis at the feet of the Clinton Administration (of which he was a part from 1993 through 1997, as Clinton’s first Secretary of Labor). Regardless of where your politics lie, it’s pretty clear that the roughly 1998-vintage annulment of venerable Glass-Steagall (which among other things created a separation between investment banking and commercial banking activities in the US) was the first in a series of major errors which eventually resulted in today’s crisis.

Add to this something Reich didn’t touch on: the Clinton administration perpetrated the second error later in its watch, when it agreed with numerous Wall Street giants that credit default swaps (the “big bad” CDSs we keep hearing about these days) ought not to be regulated. Why CDOs should have been (and must now be) regulated will be the subject of still another post, but for now let’s stipulate that CDSs are opaque derivative instruments (i.e., not only not transparent but also based on inscrutable “if…then…else” risk structures which, for lack of inspection, can mask huge exposure to global externalities) and that the practice of “netting”²  (in which an investor hedges by purchasing two CDSs with opposite and mutually-exclusive pay-off circumstances, thus “netting to zero” his exposure regardless of which of the two outcomes takes place) has exposed the entire economy to systemic risk of counterparty default. Why? Because netting (offsetting hedges) don’t work if one of the two contracts in the hedge blows up because one of the insurers—think AIG—is suddenly unable to pay. And if everyone is a counterparty to everyone else, well, you get the picture….  (My friend Paul Sheehan, who at one time was in charge of derivatives oversight at money center banks as an examiner for the NY Fed and now runs an Asian event-driven hedge fund, points out that AIG wasn’t actually defaulting;  it was merely subjected to an avalanche of “collateral calls” by counterparties who insisted that AIG set first $20 billion, then $40 billion and then $60 billion aside as collateral against their CDS obligations.)

Enter into this brewing perfect storm the High Priest of Economic Growth, Alan Greenspan, who, along with the Bush Administration, feared that the 2000/2001 bubble bursting and the tragedies of 9/11 might conspire to create a Depression. Greenspan’s Fed—amid much aplomb from the neo-supply-siders of the Bush administration—cut the Fed Funds rate so precipitously and so aggressively (down to 1.00% in early 2003) that, as Reich points out, real interest rates were negative for perhaps a year or two. I took a look at the data and produced the chart at the top of this post, and to be specific, real interest rates were negative for nearly 11 quarters (2.75 years) between 2003 and 2005.  (see figure above)  And, as others have pointed out, the problem wasn’t just negative real interest rates per se, but the fact that such low Treasury rates drove the world of investors who were looking for “safe” fixed income securities to look elsewhere—to CDOs.³

Is it any wonder that everyone and his brother who could support even a moderate credit rating borrowed like there was no tomorrow?(Don’t even get me started about the Ponzi scheme perpetrated by the rating agencies, the bond issuers and their syndicators.)Of course not. If you were a public company CFO from 2003 to 2005, you were crazy not to borrow: it was free! And what did you do with all that money?  You couldn’t invest it into real operations because you couldn’t scale that fast, and neither your business nor the economy wouldn’t support it anyway.  (That was one of many hints:  if your business can’t consume more debt without doing something off the reservation, perhaps you have no business drawing down that debt in the first place!)  And so you gamble with it.  You create demand for new and interesting securities with which to sate your demand for returns on debt you have no business generating in the first place.  So you overheat demand for CDOs, and you create an irresistible temptation for the bankers to create more and more of them.  Commercial banks did it. Investment banks did it.  Even insurance companies did it.

Thus Clinton Administration policies and Bush Administration policies created the perfect storm:

If you have been thinking about the ramifications of what the Fed did earlier this week, you can see where this is going. But that will have to wait for the next post(s)….

1. Inflation data from http://inflationdata.com/inflation/Inflation_Rate/HistoricalInflation.aspx, Fed Funds data from http://www.the-privateer.com/rates.html.  Graph by the author. [↩]
2. The best explanation of both the system risk from netting and CDSs in general I’ve come across comes from the absolutely super This American Life/NPR News collaboration “Another Frightening Show About the Economy”, itself a follow-up to an earlier and equally excellent collaboration cleverly titled “The Giant Pool of Money” [↩]
3. credit to “The Giant Pool of Money” for explaining this so clearly. [↩]

When I’m not procrastinating by writing blog posts, I’m the CEO of a Silicon Valley technology company.  For the past few weeks, while the credit crisis wrought havoc on Wall Street and some of my colleagues were forced to face the reality that the already anemic IPO market, channeling Punxsutawney Phil, was likely to go back into its hole for another six weeks year, we had mostly remained unassaulted by the crisis.  Sure, those running consumer-focused businesses were already feeling the impact of plummeting consumer confidence, but fundamentally we were confident that our venture capital investors were smart enough not to act like lemmings and assume that, just because the public markets are in trouble, so was their portfolio.  After all, Silicon Valley focuses on the long term, right?  It’s smarter, more creative, perhaps even iconoclastic . . . right??

Not so.  Enter Sequoia Capital’s “RIP Good Times” presentation.  Within a day, eight people had forwarded it to me, along with notes taken by a briefly-anonymous Sequoia portfolio CEO.  Shortly thereafter came the Benchmark Letter, which another investor and our corporate counsel both forwarded to me.  And the Ron Conway email.  The argument is that revenues and earnings will fall off the table (thus perhaps justifying the fact that today’s S&P 500 is trading at a pretty low average P/E of 10.5), thus necessitating tectonic readjustments to spending.

And there it was: in one great, coordinated movement, Silicon Valley panicked.  It was as if the Valley remembered 2000-2001 and couldn’t sleep.  A friend of mine, at a Seqoia company, worked the weekend and executed a 40% layoff earlier this week.  Hi5 cut staff, Zillow and Adbrite did the same, and the list goes on and on.  One day everything is fine;  the next, the world is ending.  Trader mentality hit Sand Hill Road.  With the zeal of the converted, a paroxysm of cost-cutting swept Valley CEOs.

This “stampede for the exits” mentality of supposedly long-term investors here in the Valley makes zero sense.  One of my Directors correctly pointed out that Moritz et al. at Sequoia were undoubtedly “firing for effect,” and I’m sure they were, but tell that to the employees laid off by my friend’s Sequoia-backed company.  The problem with making rapid adjustments to early stage companies is that the adjustments themselves effect the business.  There’s a Heisenberg Uncertainty Principle in startups:  trimming too fast or too precipitously will injure the company far more deeply than it would a larger, established company.  Why?  Because start-ups in particular rely on their employees to go the extra mile, think the impossible is possible, burn the midnight oil, and invent the ingenious.  They also rely on their employees knowing they’re involved in something special, relishing their creative environment, and collaborating with their colleagues.  (For which, of course, they need to have colleagues…!) Take all that away, and a start-up is just a thinly-staffed, under-capitalized company with no track record or proven market.

There’s another, more profound risk, however:  react too strongly and Heisenberg will assure your startup misses the market opportunity it’s not expecting.  The problem with over-optimizing, particularly in venture-backed companies, is that they will miss the unexpected, creative opportunity, either because they are so busy dealing with the ramifications of precipitous cost-cutting or because they will be so under-staffed and so hyper-focused on cash flow that they will have neither the energy nor the creative spirit to do something daring when the opportunity presents itself.

Does this mean we should be spending profligately and ignoring the broader dynamics of the economy?  Of course not.  No CEO in his or her right mind would do so.  But the fact remains that what makes Silicon Valley great is certainly not its ability to play the part of proverbial “tail” to the economic dog which wags it.  Every one of us should take a careful look at our spending, our sales forecasts, and make sensible business decisions based on what we see.  (In our case, we see changes coming and are adjusting for them.  We’re cutting where we need to, investing where we can afford to, and otherwise treating the shake-up as an opportunity to test every single one of our assumptions.  And, yes, if one of those assumptions changes and we see a problem, then we’re going to cut spending.)  But lay off 40% of staff just because someone gave a presentation?

Fortunately, voices of sanity have begun to speak up.  My friend and colleague Pascal Levensohn (full disclosure: also now an investor and Board member in my company) wrote an excellent post today putting context around the Sequoia presentation.  And none other than the Sage of Omaha himself is going long on US equities.  All of us running businesses under these economic circumstances are well-served to create a back-up plan (the “survival plan”), take a whack at expenses wherever and whenever possible (hey, shouldn’t we be doing that all the time anyway?), test every single assumption in our models, and perhaps think long and hard before hiring additional staff.  But then we should go back to work, build amazing businesses, and remember that Silicon Valley is about the future and we’re in charge of creating it.

I don’t blog about technology all that often, but occasionally something appears which is sufficiently ground-breaking to merit a post.  Blogging from 6.5 miles above the earth qualifies.

It was a pleasant surprise to discover that my American Airlines flight this evening from JFK to SFO is one of those graced with in-flight Internet service, courtesy of GoGo Inflight Internet (and a nice revenue-sharing deal with American Airlines, no doubt).  It’s an even more pleasant surprise to report that the service is superb.  I just tested my bandwidth and came up with a surprising 2.4Mb downstream (haven’t done an upstream test, but I just emailed a 12Mb file to a colleague who got it reasonably quickly).

To put it mildly, I suspect these services will have an immediate and profound impact on my personal inflight productivity.  There are some silly For one thing, it will probably make “offline availability” a little less important for some of my company’s internal enterprise applications (NetSuite comes to mind, as does Sharepoint).  Moreover, I’m in the middle of two negotiations, and it’s refreshing not to go dark on them for five hours while I fly across the country.  Of course this service opens up all sorts of interesting etiquette questions.  For example, my seat-mate and I exchanged cards and “nice to meet you” emails while aloft (total “send button to new mail bing-bong on other computer” time of 15 seconds, including two Exchange servers and two VPNs—impressive).  Is the protocol to add each other to LinkedIn after the flight or during?  And what about VOIP calls?  (I’m pleased to report that GoGo says it’s blocking VOIP, a decision of which I’m heavily in favor.)

Of course, let’s not forget the side benefits.  I’m listening to my “Office” Pandora stream (zero hiccups, credit both Pandora‘s excellent Flash app and GoGo) and tracking my flight location:

My Flight Location: American 177 on 9/22, in real time

I’ll have to check the traffic back home before I land….